Yves here. The pipe-bombing attempts of foreclosure victim Cesar Sayoc is a reminder that the damage done by the mortgage crisis lives on in many ways.
Carolyn Sissoko does an in depth takedown of a new paper on the HAMP mortgage program, which was a major tool that Treasury Secretary Timothy Geithner used to “foam the runway” for banks servicers. To put it more bluntly, its objective was spread out foreclosures over time by (merely) delaying the onset of some. As many parties, including your humble blogger, argued at the time, even when borrowers did get modifications, they were typically only payment reductions and not even forgiveness of some of the interest. The term of the mortgage and the principal were often both increased, meaning the borrower was merely allowed to defer some of his outlay. By contrast, we argued that meaningful reductions in principal were economically sound, particularly since, due to the high level of foreclosures, losses were much higher than historical norms. Lenders used to recover ~70% in a foreclosure. In the post crisis era, 30% to 40% was more common, giving vastly more room for principal writedowns that would help investors, borrowers, and communities.
The wee problem with this line of thinking was that mortgage servicers were paid to foreclose, not to modify loans, and modifying loans well is a lot of work. Second, in a mortgage securitization, the owners of the most junior bond tranche that was still paying out would lose out in a modification (they’d be getting interest only payments, which would disappear in a principal mod due to the interest obligation being reduced along with the principal) and they’d fight modifications.1
Today, we will post Sissoko’s overview and first post, and will publish her second installment Thursday and her final piece Friday.
By Carolyn Sissoko, who has a PhD in economics from UCLA and a JD from the University of Southern California. She is an independent researcher who writes on financial regulation, the history of banking, and monetary theory. Originally published at Synthetic Assets
HAMP and Principal Reduction: An Overview
I spent the summer of 2011 helping mortgage borrowers (i) correct bank documentation regarding their loans and (ii) extract permanent mortgage modifications from banks. One of things I did was check the bank modifications for compliance with the government’s mortgage modification program, HAMP, and with the HAMP waterfall including the HAMP Principal Reduction Alternative. At that time I put together HAMP spreadsheets, and typically when I read articles about HAMP I go back to my spreadsheets to refresh my memory of the details of HAMP.
So when I learned about a paper that finds that HAMP “placed an inefficient emphasis on reducing borrowers’ total mortgage debt” and should have focused more on reducing borrowers payments in the short-run — which goes contrary to everything I know about HAMP, I decided to read the paper.
Now I am an economist, so even though my focus is not quantitative data analysis, when I bother to put the time into reading an econometric study it’s not difficult to see problems with the research design. On the other hand, I usually avoid being too critical, on the principle that econometrics is a little outside the area of my expertise. In this case, however, I know that very few people have enough knowledge of HAMP to actually evaluate the paper — and that many of those who do are interested parties.
The paper Peter Ganong and Pascal Noel’s Liquidity vs. wealth in household debt obligations: Evidence from housing policy in the Great Recession. This paper has been published as a working paper by the Washington Center for Equitable Growth and NBER, both of which provided funding for the research. Both the Wall Street Journal and Forbes have published articles on this paper. So as one of the few people who is capable offering a robust critique of the paper, I am going to do a series of posts explaining why the main conclusion of this paper is fatally flawed and why the paper reads to me as financial industry propaganda.
Note that I am not making any claims about the authors’ motivation in writing this paper. I see some evidence in the paper to support the view that the authors were manipulated by some of the people providing them with the data and explaining it to them. Overall, I think this paper should however serve as a cautionary tale for all those who are dependent on interested parties for their data.
Here is the overview of the blogposts I will post discussing this paper:
HAMP and principal reduction post 1: The ideology of financialization
HAMP and principal reduction post 2: What’s the problem with financialization?
HAMP and principal reduction post 3: A regression discontinuity error
The principal result in the paper is invalid, because the authors did not have a good understanding of HAMP and of HAMP PRA, and therefore did not understand how the variable they use to distinguish treatment from control groups converges to their threshold precisely when principal reduction converges to zero. The structure of this variable invalidates the regression discontinuity test that the authors perform.
The analysis in Peter Ganong and Pascal Noel’s Liquidity vs. wealth in household debt obligations: Evidence from housing policy in the Great Recession is an object lesson in the ideological underpinnings of “financialization”. So this first post in my HAMP and principal reduction series dissects the general approach taken by this paper. Note that I have no reason to believe that these authors are intentionally promoting financialization. The fact that the framing may be unintentionally ideological makes it all the more important to expose the ideology latent in the paper.
The paper studies government and private mortgage modification programs and in particular seeks to differentiate the effects of principal reductions from those of payment reductions. The paper concludes “we find that principal reduction that increases housing wealth without affecting liquidity has no significant impact on default or consumption for underwater borrowers [and that] maturity extension, which immediately reduces payments but leaves long-term obligations approximately unchanged, does significantly reduce default rates” (p. 1). The path that the authors follow to arrive at these broad conclusions is truly remarkable.
The second paragraph of this paper frames the analysis of the relative effects of modifying mortgage debt by either reducing payments or forgiving mortgage principal. This first post will discuss only the first three sentences of this paragraph and what they imply. They read:
The normative policy debate hinges on fundamental economic questions about the relative effect of short- vs long-term debt obligations. For default, the underlying question is whether it is primarily driven by a lack of cash to make payments in the short-term or whether it is a response to the total burden of long-term debt obligations, sometimes known as ‘strategic default.’ For consumption, the underlying question is whether underwater borrowers have a high marginal propensity to consume (MPC) out of either changes in total housing wealth or changes in immediate cash-flow.
Each of the sentences in the paragraph above is remarkable in its own way. Let’s take them one at time.
The normative policy debate hinges on fundamental economic questions about the relative effect of short- vs long-term debt obligations.
This is a paper about mortgage debt – that is, long term debt – and how it is restructured. This paper is, thus, not about “the relative effect of short- vs long-term debt obligations,” it is about how choices can be made regarding how long-term debt obligations are structured. This paper has nothing whatsoever to do with short-term debt obligations, which are, by definition, paid off within a year and do not figure in paper’s analysis at any point.
On the other hand, the authors’ analysis is short-term. It evaluates data only on the first two to three years (on average) after a mortgage is modified. The whole discussion takes it as given that it is appropriate to evaluate a long-term loan over a horizon that covers only 5 to 10% of its life, and that we can draw firm conclusions about the efficiency of a mortgage modification by only evaluating the first few years of the mortgage’s existence. Remember the authors were willing to state that “principal reduction … has no significant impact on default or consumption for underwater borrowers” even though they have no data on 90 – 95% of the performance of the mortgages they study (that is, on the latter 30-odd years of the mortgages’ existence).
Note that the problem here is not the nature of the data in the paper. It is natural that topical studies of mortgage performance will typically only cover a portion of those mortgages’ lives. But it should be equally natural that every statement in the study acknowledges the inadequacy of the data. For example, the authors could have written: “principal reduction … has no significant impact on immediate horizon default or immediate horizon consumption for underwater borrowers.” Instead, the authors choose to discuss short-term performance as if it is all that matters.
This focus on the short-term, as if it is all that matters, is I would argue the fundamental characteristic of “financialization.” It is also the classic financial conman’s bait and switch. The key when selling a shoddy financial product is to focus on how good it is in the short-term and to fail to discuss the long-term risks. When questions arise regarding the long-term risks, these risks are minimized and are not presented accurately. This bait and switch was practiced on municipal borrowers who issued adjustable rate securities and purchased interest rate swaps, on adjustable rate mortgage borrowers who were advised that they would be able to refinance before the mortgage rate adjusted up, and even on the Trustees of Harvard University, who apparently entered into interest rate swaps without bothering to understand to long-term obligations associated with them.
The authors embrace this deceptive framework of financialization whole-heartedly throughout the paper by discussing the short-term performance of long-term loans as if it is all that matters. While it is true that there are a few nods in footnotes and deep within the paper to what is being left out, they are wholly inadequate to address the fact that the basic framing of the paper is extremely misleading.
For default, the underlying question is whether it is primarily driven by a lack of cash to make payments in the short-term or whether it is a response to the total burden of long-term debt obligations, sometimes known as “strategic default”2
The second sentence is based on the classic distinction between a temporary liquidity-driven stoppage of payments and a stoppage due to negative net worth – i.e. insolvency. (Note that these are the two long-standing reasons for filing bankruptcy.) But the framing in this sentence is remarkably ideological.
The claim that those defaults that are “a response to the total burden of long-term debt obligations” are “sometimes known as ‘strategic default’” is ideologically loaded language. Because the term “strategic default” has a pejorative connotation, this sentence has the effect of putting a moralistic framing on the problem of default: liquidity-constrained defaults are implicitly unavoidable and therefore non-strategic and proper, whereas all non-liquidity-constrained defaults are strategic and implicitly improper. This framing ignores the fact that a default may be due to balance sheet insolvency, which will necessarily be “a response to the total burden of long-term debt obligations” and yet cannot be classified a “strategic” default. What is commonly referred to as strategic default is the case where the debtor is neither liquidity constrained, nor insolvent, but considers only the fact that for this particular asset the payments are effectively paying rent and do not build any principal in the property.
By linguistically excising the possibility that the weight of long-term debt obligations leads to an insolvency-driven default, the authors are already demonstrating their bias against principal reduction and once again exhibiting the ideology of financialization: all that matters is the short-term, therefore balance sheet insolvency driven by the weight of long-term debt does not need to be taken into account.
In short, the implicit claim is that even if the borrower is insolvent and not only has a right to the “fresh start” offered by bankruptcy, but likely needs it to get onto his or her feet again, this would be “strategic” and improper. Overall, the moralistic framing of the paper’s approach to debt is not consistent with either the long-standing U.S. legal framework governing debt which acknowledges the propriety of defaults due to insolvency, or with social norms regarding debt where business-logic default (which is a more neutral term than strategic default) is common.
For consumption, the underlying question is whether underwater borrowers have a high marginal propensity to consume (MPC) out of either changes in total housing wealth or changes in immediate cash-flow.
The underlying assumption in this sentence is that mortgage policy had as one of its goals immediate economic stimulus, and that one of the choices for generating this economic stimulus was to use mortgage modifications to encourage troubled borrowers to increase current consumption at the expense of a future debt burden. In short, this is the classic financialization approach: get the borrower to focus only on current needs and discourage focus on the costs of long-debt. Most remarkably it appears that Tim Geithner actually did view mortgage policy as having as one of its goals immediate economic stimulus and that this basic logic was his justification for preferring payment reduction to principal reduction.
Just think about this for a moment: Policy makers in the midst of a crisis were so blinded by the ideology of financializaton that they used the government mortgage modification program as a form of short-term demand stimulus at the cost of inducing troubled borrowers (i.e. the struggling middle class) to further mortgage their futures. And this paper is a full-throated defense of these decisions.
The ideology of financialization has become powerful indeed.
Financialization Post 2 will answer the question: What’s the problem with the ideology of financialization?
1 Mind you, I am skeptical as to how serious these threats were since servicers had incentives to play them up. The flip side is the FDIC made a concerted effort in 2010 to come up with ways to do mortgage modifications and they were stymied by the “tranche warfare” problem.
2 “Strategic default” was a meme that appeared with such suddenness after the crisis that it did not look organic. And as Sissoko points out, the idea that someone who defaulted before they were utterly broke was somehow abusing the system was widely accepted in the business press despite its lack of a logical or factual foundation. Someone who defaulted lost their house and everything that went with it: attachment to the neighborhood, whatever sweat investment they had made, all of the decorating. On top of that, they also trashed their credit score, which would not only hurt their ability to borrow but would also hurt them in the job market. Moreover, people who lose their houses still need to live somewhere. So if a borrower defaulted before he was totally out of dough so he’d have enough to put down a deposit on a rental and be able to move his goods, this paper would treat that as a “strategic default” as opposed to an anticipatory default (ie, the borrower knows he won’t be able to keep the house and exits before he is utterly destitute).